Why your mortgage rate might rise, even if the RBA sits tight

By Clancy Yeates

A flood of smaller banks have hiked interest rates recently and this is worth noting even if you're one of the 80 per cent of borrowers who bank with the big four.

Sure, so far the major banks have resisted raising their own mortgage rates – which would surely make them an even bigger political target.

Official interest rates are unlikely to change anytime soon, but some analysts think the big banks will raise the interest rates they charge.

Photo: Rob Homer

But the big lenders confront similar financial issues to their small rivals and this means they face a dilemma. Do they let shareholders, depositors and business borrowers wear the pain from a squeeze on their profit margins from higher funding costs? Or do they risk a political backlash by also raising costs for homeowners?

In the financial markets, most economists think the Reserve Bank won't move official rates for about another year, possibly longer. But many experts think commercial banks – which set the rates we actually pay – will probably make the unpopular choice and raise rates before the RBA moves. Here's why.

Most of us don't really understand, or particularly care, about what goes into a bank's funding costs. Fair enough. But the chart highlights a trend that may well affect you, if you have a mortgage.

The graph shows the sharp slowdown in growth in "broad money" – which refers to currency and cash held by banks in deposits. Broad money is now growing at its slowest pace since 1993 and the gap between its growth and credit growth is the widest in more than a decade.

Normally economists wouldn't care much about this. The money supply used to have a big impact on how interest rates were set in the 1970s and early 1980s, but HSBC's Paul Bloxham says the theory is now largely "defunct" for market economists.

However, the current numbers are more interesting. The sharp slowdown in money growth implies banks may need to start paying more for increasingly scarce deposits.

Indeed, some smaller lenders are already doing this, though it's only been a marginal change so far. Deposits make up about 60 per cent of bank funding, so higher deposit rates should ultimately result in more expensive mortgages.

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No one knows for sure, but Bloxham says a likely explanation is that businesses' cash on deposit has been growing at a much slower rate – perhaps because companies are using their cash to fund investment. Superannuation funds have also been expanding their deposit holdings more slowly, with speculation they're moving the cash overseas instead, where they can get a higher return.

Some had also thought funds were drying up because banks needed to secure funds before the end of the financial year – though this is looking less likely, now that we're through July.

Whatever the exact causes, the slowdown in "broad money" growth comes as the banks are being forced to pay more in wholesale markets, where they get another big chunk of their funding.

We know this because there's been a blowout in the gap or "spread" between the three-month bank bill swap rate (BBSW), an interbank funding market, and the overnight index swap, which reflects bets on the path of official interest rates.

This closely-watched number directly affects the cost of banks' wholesale borrowings, and it's widened by 0.25 percentage points in December to 0.55 percentage points in the latest June quarter.

Left unchecked, these trends will likely cut hundreds of millions from the big four's collective profits.

AMP Capital chief economist Shane Oliver points out funding costs have been elevated for about six months now, suggesting there may be some deep-seated cause.

"It's starting to look structural," he says.

Banks can either take the hit to profit, or pass on the impost to some of their depositors or their home loan customers. CBA and Westpac have recently taken the knife to some of their deposit rates, but logic (and history) suggests borrowers will probably feel the pain eventually.

That's why some analysts, though not all of them, are predicting a smallish interest rate rise from the big banks of about 0.1 percentage points. The increase would probably be larger for property investors or those with interest-only loans.

Yes, jacking up home loan rates while bank behaviour is under the glare of a royal commission would spark more fury from politicians. But it would be surprising if the banks absorbed this extra cost indefinitely.